Gordon Growth Model (GGM)

  • The GGM is a variation on the standard DDM that allows the analyst to assume that dividends will grow in perpetuity at a constant rate.

V0 = Div1 /(rce - gdiv)

  • Div1 = D0 * (1 + gdiv) = future period dividend payment

  • rce = by now you should know this!

    In an exam problem CFA might make you derive the required return on common equity via CAPM.

  • gdiv = growth rate of the dividend

  • Note that in order for GGM to "work", the required return on common equity must be greater than the expected growth rate of the dividend.

  • GGM can also be used to value preferred stocks, whose dividend payments are fixed.

Preferred Stock V0 = Pref Div /r preferred stock

  • GGM can be appropriate when:

  • The analyst is looking at broad equity indexes.

  • The analyst is valuing steadily growing companies that pay dividends.

  • GGM has drawbacks of:

  • Being incredibly sensitive to small changes in the model inputs.

  • An inability to value companies that do not pay dividends.

  • An inability to value companies whose growth is not stable.

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